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Rev. Rul. 1969-440

Revenue Rulings

Internal Revenue Service
Revenue Ruling
Rev. Rul. 69-440
1969-2 C.B. 46
Sec. 316
IRS Headnote
If total distributions for two classes of stock are in excess of earnings
and profits, dividends must be regarded as having been distributed to those
stockholders having priority under corporate charter before any
distributions to stockholders with lesser priority; G.C.M. 21122
superseded.
Full Text
Rev. Rul. 69-440 /1/
The purpose of this Revenue Ruling is to update and restate under the
current statute and regulations the position set forth in G.C.M. 21122,
C.B. 1939-1 (Part 1), 187.
The question presented concerns the source of distributions under section
316 of the Internal Revenue Code of 1954 and section 1.316-2 of the Income
Tax Regulations when such distributions are made with respect to classes of
stock having priority over other classes of stock and the sum of the
payments on all classes for the year is in excess of the earnings and
profits.
In 1968 a corporation had outstanding common stock, prior preferred
cumulative stock entitled under the corporate charter to dividends at the
rate of $6 per share before the payment of any dividend on any other class,
and cumulative convertible stock entitled to cumulative dividends at the
rate of $2 per share. During the year the corporation made distributions on
the prior preferred stock in the total amount of $6 per share and on the
cumulative convertible stock in the total amount of $2 per share. The total
amount distributed in 1968 was 35x dollars but the corporation had earnings
and profits for the taxable year 1968 of only 24x dollars and had no
accumulated earnings and profits as of January 1, 1968. The earnings and
profits of the corporation were sufficient to cover the dividend
requirements on the prior preferred stock, and if applied first to the
dividends on that stock, would leave earnings and profits to be applied to
the dividends paid on the cumulative convertible stock equal to 12 percent
of the amount distributed to holders of such stock. On the other hand, if
the earnings and profits were prorated as to all the dividends paid, 68.57
percent of the amount received by the holders of each class of stock would
be regarded as a distribution of earnings and profits and the remainder
would constitute a distribution of capital. Section 1.316-2 of the
regulations provides that if the distributions made during the taxable year
exceed the earnings and profits of such year, that proportion of each
distribution that the total of the earnings and profits of the year bears
to the total distributions made during the year shall be regarded as out of
the earnings or profits of that year.
There is nothing in section 316 of the Code which impairs the contractual
right of the stockholders. The pertinent portion of that section reads as
follows:
"Sec. 316. Dividend Defined.
(a) General Rule.--For purposes of this subtitle, the term "dividend" means
any distribution of property made by a corporation to its shareholders--(1)
* * *, or (2) out of earnings and profits of the taxable year (computed as
of the close of the taxable year without diminution by reason of any
distributions made during the taxable year), without regard to the amount
of the earnings and profits at the time the distribution was made."
This provision is substantially the same as section 115(a). In explanation
of the last clause, the Senate Committee on Finance in its report on the
1936 revenue bill (Report No. 2156, June 1, 1936, page 18) stated:
"In order to enable corporations without regard to deficits existing at the
beginning of the taxable year to obtain the benefit of the dividends paid
credit for the purposes of the undistributed profits surtax, section 115(a)
changes the definition of a dividend so as to include distributions out of
the earnings or profits of the current taxable year. The amendment
simplifies the determination by providing that distributions during the
year, not exceeding in amount the current earnings, are dividends
constituting taxable income to the shareholder and a dividends paid credit
to the corporation. As respects such dividends the complicated
determination of accumulated earnings or profits is rendered unnecessary."
Thus, it appears that Congress intended that a corporation should compute
its net earnings and profits as of the end of the year, and that if
dividend distributions had been made in excess of that amount, the amount
of each distribution that was paid out of earnings and profits would be
determined on the pro rata basis rather than looking to the actual earnings
on hand at the time of each distribution. However, it does not follow that
where dividends are paid to different classes of stockholders the
priorities as between stockholders must be disregarded. If, for example, a
corporation earns only an amount sufficient to meet its preferred stock
requirements and pays the required dividends on its preferred stock and
also makes distributions on its common stock, the preferred stockholders
should, nevertheless, report as dividends the entire amount distributed to
them even though the corporation also made distributions to its common
stockholders which, when added to the preferred stock dividends, were in
excess of the corporate earnings and profits for that year. In such a case,
if the preferred stockholders are entitled to payment of their dividends
before any distribution can be made to common stockholders, it is apparent
that the earnings and profits are used first for the preferred
stockholders, and if the earnings and profits are thereby exhausted, the
payments to the common stockholders merely reduce their equity and
constitute in effect a return of capital.
The right of a preferred stockholder to preference out of the earnings of
the corporation for each year was recognized in Barclay et al. v. Wabash
Ry. Co. et al., 30 F. 2d 260 (1929), wherein the court granted a decree
forbidding payment of the dividends on junior stock out of earnings
accumulated during the year for which the preferred dividends had not been
paid. Thus, the preferred stockholders have an equitable claim on the
earnings of the corporation for each year that must be met before any part
of those earnings can be paid to other classes of stockholders.
Accordingly, in the present case, the earnings and profits must be regarded
as having been first used for the payment of the dividends on the prior
preferred stock as required by the charter of the corporation and the
contract with the prior preferred stockholders, and only the earnings and
profits remaining after such dividend requirements have been met should be
regarded as having been paid to the junior stockholders. In other words,
the earnings and profits of the corporation for the year 1968 must be
regarded as having been distributed in accordance with the provisions of
the corporate charter giving the prior preferred stockholders the right to
dividends before any earnings and profits can be distributed to the other
stockholders.
G.C.M. 21122 is hereby superseded since the position stated therein is
restated under current law in this Revenue Ruling.
/1/ Prepared pursuant to Rev. Proc. 67-6, C.B. 1967-1, 576.